Insights or analysis from Financial Statements: Balance Sheet, Income Statement and Cash Flow Statement

[Surender]

As one progresses in the art of learning equity analysis, analysis of Financial Statements: Balance Sheet, Income Statement and Cash Flow Statement is an important exercise, which becomes really daunting in case one, like me, comes from non-finance background. The intent to start this thread is to share and learn this important aspect by using the generous help available @ Valuepickr from experienced practitioners of this art. As of now, I am posting the details of the Balance sheet (BS)-taken from screener.in which does an excellent job of grouping the assets and liabilities from investors point of view - of a company (whose name is masked intentionally to avoid the biases in the responses) and Subsequently, after sometime, the thread would progress to next statements. From the below image of the BS, what are the details one can think of on the questions such as:
What are the likes/dislikes in this BS?
What kind of business one predicts by seeing the BS?
Quality of business? Bad, Good, Better… Why?
What questions come to mind that need to be looked in the annual report for more details?
What Insights -patterns and information - experienced investors, such as our beloved torchbearers such as @ayushmit, @Donald, @desaidhwanil, @hitesh2710 and @basumallick, derive from this data?

Any other details?
Open for your Insights/suggestions/Criticism.

Below excel has all the data:
BS-C.xlsx (13.1 KB)

[Surender]

First and Foremost, The Accounting Equation, which everyone must know:

Now, let’s look at the Equity and Liability Section of the Balance sheet (BS)- reformulated as Common Size, which means that all the heads are shown in % terms with respect to the total value:

Insight 1: Company does not use borrowing or debt as a source of fund. Implies, business seems to be doing good as they hardly took any debt in last 10 years.
Insight 2: Other Liabilities/Other People money provides almost half (46% in FY17) of the funding to conduct the business. Implies, a source of funding without interest, and Collateral.

[ashit]

It seems negative capital employed

Disclosure
I am from medical Field
But it’s no excuse
Thanks
Ashit

[Surender]

Yes @ashit. You are right on money. But the book definition of working capital can not be employed here as that needs the data under the heads of Current assets and Current liabilities. I have slightly modified the concept to use the existing data and consider this concept as an important area to focus as an investor…
Here you go:

Insight3: If the trend of R+I-P (Receivables+Inventory-Trade Payables) for a business is toward a negative value, business could be a good candidate to explore further.

In nutshell, it seems to be a good business due to the presence of investments and surplus Cash, absence of debt and Negative Working Capital.

Question 1: Is the business fixed capital intensive as the 54.1 % (47% +7.1%) of the assets are tied up in Long term/Fixed assets?
–Need to look at total sales from Income statement to calculate the Fixed Asset Turnover.
Question 2:What are the investments that the company is holding?
–Need to look at the respective accounting note in the Annual Report(AR).

P.S: Inspired and Influenced by the various articles that are written by Prof. Sanjay Bakshi on this topic.

[ashit]

Excellent write-up surender

Still i can guess from your original balance sheet that it must having good ROIC as denominator is vary less (low equity and nil borrowing and negative capital employed)

Thanks
Ashit

[Surender]

@ashit

good ROIC

Yes instead of May be and an Investor would always wish to own a company with good ROIC…It could be confirmed after looking at income statement. Help us all by elaborating that why it’s important for an investor?.
As of now, I would park your idea in order to continue with the balance sheet (BS) exploration as there are more wrinkles to be ironed out before Income statement is introduced and finally the number crunching starts by establishing the relation between BS and Income statement.
Your comment is much appreciated as I felt that it would be the least read thread due to lack of any mention about the PRICE and NAME of an equity. Most of the People, including yours truly, who are engaged in equity buying love to know the PRICE of an equity,and invest most of their equity analysis time to check the price at regular frequency

I hope that notes in this thread and screener.in makes it easy to infer that BS is easy to understand. Still, why our thoughts are imbalanced as soon as we see a balance sheet. I think that devil lies in overwhelming details such as Values in Thousand/Lac/Crores, different terminologies, lots of headers to make sense, lack of purpose while staring at these numbers and lack of knowledge in the field of finance are few of the reasons for the same . Here is the real snapshot, with all the details, from the BS.

Also, I have done the calculations for Working Capital (thanks that you prodded) and Book Value (BV) for FY17 in the below image.

Refer below excel file for latest data changes.
BS-C.xlsx (21.3 KB)

[Surender]

The Debt Factor or The Kiss of Bankruptcy or The ratio of Debt to Equity:
Good News! There is no Debt in the B.S of the example company, so you can skip to read the rest of the blabbering.
BUT Wait…, What if it existed? Curious to know, Join in further!!
Not only the amount but also the kind of Debt needs a special attention from an investor.
Why?
Debt is the ONLY REAL number on the face of the balance sheet in case the company faces a crisis either due to internal factors (operations) or external factors (related to credit market) whereas all other numbers may not yield the face value whenever a company is up for a fire sale.
Importance of Debt factor multiples in case one is analyzing a company among turnarounds and troubled companies. It’s the debt more than anything else that determines which companies will survive or go bankrupt in a crisis.
Kinds of debt:
1- Bank Debt from Banks or Commercial Paper that is inter-company loans: Worst kind from shareholders point of view as it’s “Due-On-Call”. At the first sign of trouble, lender can ask for Principal repayment. What if the borrower is unable to pay? Lender can strip off the company by pushing for bankruptcy, and nothing might be left for a shareholder.
2- Funded Debt: BEST kind from shareholders point of view as principal cannot be called on until the due date, which might be after 10, 15 or 20 years, as long as Interest payment is done by the borrower even if debt is downgraded by rating agency. Example- Corporate bonds with long maturity.
Know the Purpose for debt. What if company loads up debt but continues to pay dividend? How do you feel? Few more points to note are:
1- Better if debt is long-term, Investment Grade, and Non-Recourse (secured by specific asset) with staggered maturity.
2- Business with Steady Cash Flow can handle huge debt
3- Keep in an eye on Off Balance sheet debt such as Lease Obligations, Warranties Purchase Contract, and Unfunded Pension Plan.

Regarding amount, limit your investment to companies that does not have a debt factor of more than 0.5 to avoid reading and making sense of “N” types of variables about debt. But, if you are adventurous kind and not scared to learn and understand, then the debt factor of 0.5 is not a limit for you!!

Please share your lessons learnt- best if you have some real examples from Indian markets- as I understand that my note is all theory and does need some real examples, that I lack.

P.S : Inspired and influenced by the book “One Up Wall Street”.

[Surender]

Book Value (BV):
One of the most easily available number besides Price and EPS. Be careful, to take it on face value. Just imagine, you bought a brand new car, which has just reached home and due to some unforeseen emergency you have to sell it off. Will you get the value, which is recorded in your books? NO!
Let’s invert, your old car is used by Salman Khan in one of his movies. Will you get the value, which is recorded in your books? NO….You will get way more than BV due to the X-factor.
So, BV as a number does not represent the true worth of a company. It might understate or overstate the value.You buy a company on the basis of BV and it’s losing money in operations or accumulating inventory without any demand for the product at snowballing pace without any plans to stop/contain the same. One fine day, BV would vanish. On the other side, BV might contain hidden assets such as Land in Prime location which can be monetized or Brand/Patents etc. which are depreciated, until they disappear from the asset side of the BS or /tax breaks due to previous losses.So, read the AR’s to know –What makes up the BV? More important to do so if you are buying the shares on the basis of BV.

Inventories:
FIFO (First-In-First-Out) or LIFO(Last-In-First-Out) are the two basic accounting methods.
On a lighter note, two other popular methods, really happens to lot of inventories, are GIGO(Garbage-In-Garbage-Out and FISH(First-In-Still-Here).
Too much confusion, what to look for?
See the trend of inventory w.r.t the sales. Also, See Insight 7.

Insight4: Watch the trend of the Debt factor or Long-Term Debt…See the details of last 10 years, if possible!! Debt reduction over the 10 years is a sign of prosperity. Keep in mind that the Debt factor shows financial strength of a company. Does the company has an overwhelming Pension obligation as these are absolute obligations to pay?
Insight5: Short-term debt can be ignored incase cash on BS or other current assets (inventories, receivables etc.) can cover up for the same.
Insight6: If cash exceeds debt, rest assured that company is not going out of business. Increasing cash relative to debt is a sign of improving BS.
Insight7: It’s a RED FLAG, when inventories grow faster than sales. It’s first sign of turnaround, when inventory start reducing for a depressed company.

The company, used as an example, is financially strong as there is no long term debt in the BS and would not go out of the business due to lack of money.

Question 3: Is the cash real? Where is it kept? Why is it kept?
Question 4: What are the finer details of the debt?
Question 5: What are the components of Book Value?
To answer the above questions, Annual reports/Conference Calls/Investor communication Presentation are needed. Just imagine, AR of last 10 years and each AR contains ~200 of pages. Overwhelming situation and sure shot chance to lose interest in the AR, if one does not know the questions to look for.

Hmm…Too much details, I know.
Let’s take the easy route. Stare at the price of shares you hold at a greater frequency. The stare and frequency might shoot up the Price

[Surender]

In the nutshell, Keep in mind that BS has
1- Assets: Financial & Operational(key among these are Inventory and Receivables)
2- Liabilities: Equity, Debt and Other People Money (Trade payable).

Most important parameters to watch out for are R+I-P, Debt Factor, Net Debt and Net Operational assets.

Below Picture might help to cut all the noise from details and be worth hundreds of words, if not thousands:

Here is the updated excel in case anyone is interested to see the calculation details, do point out the mistakes or flaws.
BS-C.xlsx (39.9 KB)

As of now, I would take a pause to recheck my dusted books to find anything more to add on Balance sheet. Till than, Open for your comments and contributions.

[rkothuri]

Thanks Surender for educating on Balance sheet.

Here are couple of things that we can deduct:

1. Company has done good amount of expansion in FY13-14 and used the cash/investments for funding the expansion instead of debt. Net block has increased
   

2. No equity dilution. I think there were bonus shares in FY15-16.

[DrArvind]

[quote=“rkothuri, post:10, topic:12087”]
I think there were bonus shares in FY15-16.
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@rkothuri

No equity dilution

As EPS is diluted than why there is no equity dilution? Did you mean that due to bonus issue current share holder’s wealth would remains same after that bonus/equity dilution? Then split would create the same to the wealth of the current shareholder’s stake then why it is called as equity dilution

[svsrikanth]

Nice article helps ppl like me to understand some concepts of BS.

[rkothuri]

I thought equity dilution is where the earnings per share actually reduce because there are more shares for the same earnings. For share splits, bonus shares the actual earnings reduce but the at the same time number of shares do increase at the same proportion. Whereas in case of QIP, FIP or ESOPs there are more outstanding shares and the actual EPS is per share is reducing.

Note: I am new to investing and might be wrong. Let’s learn together.

[Surender]

I believe that any action of issuing more equity such as FPO, Rights Issue or QIP that brings additional money in to the company should be termed as Equity Dilution. Thinking in terms of EPS reduction as equity dilution does not seem correct as that puts Bonus as well as Split actions in the category of equity dilution although they do not bring additional money to the company. Bonus and Split do make the stock affordable to masses and result in positive sentiments among the investors.

[DrArvind]

@Surender are bonus or split have any impact on balance sheet of the company in respect to the reserve ? Is there any clue in balance sheet from which one can predict that particular company is suitable candidate for issuing bonus in the near future?

[Surender]

Split: No effect on Reserves & surplus.
Bonus: Yes it does affect Reserves & surplus.
Shareholder’s fund is kept in two buckets named as Reserves & surplus and Share Capital. To issue bonus share, money is taken from Reserves & surplus and moved to Share Capital. See the below snapshot for details with regard to the company used as an example:

In the nutshell, total amount of Shareholder’s fund is unchanged. Why to issue bonus share? This is the rationale given by the company:

Regarding the below:

@DrArvind

Is there any clue in balance sheet from which one can predict that particular company is suitable candidate for issuing bonus in the near future?

I have no idea to get a clue from balance sheet but I believe that high price of stock could be a valid reason but not always. I do not see a reason why the ability to pay bonus shares be of any interest to an investor.

[rkothuri]

More basic question:

Where did reserves and surplus sit? I.e. does it exists in form of cash?

What does it mean by saying x amount is transferred to reserves and surplus?

[Surender]

Till date, all the earnings of the company that is not distributed to the shareholders is accumulated under Reserves and surplus.As an analogy, it’s similar to all the savings done by an individual. Now, think for a moment that where the savings of an individual sits? Individual could invest the savings to various kinds of assets such as Land, House, Stocks, FD’s, Insurance, cash etc. Similarly company could be using it for various assets (long term/short term) and some may be in the form of cash as cash is also part of the assets.

@rkothuri

What does it mean by saying x amount is transferred to reserves and surplus?

I believe that the above implies that X amount of earnings from current earnings is accumulated to Reserves and surplus

Trust that helps.

[mudit1712]

@Surender

definition of working capital can not be employed here as that needs the data under the heads of Current assets and Current liabilities. I have slightly modified the concept to

can you please explain it using some equation how do you came to the conclusion for negative cash flow…

[Surender]

I think you meant negative working capital and not the cash flow. Please look at the snapshot shown in 6/20 in this thread. Working capital=Current Assets-Current Liabilities and the value is negative for this company.